Some like to believe the best investors must have the instincts for spotting a bargain amongst the thousands of shares in the market. But what discipline does a good investor possess that enables them to outperform the average over long periods of time?
A checklist approach for investing comes highly recommended if you truly wish to outperform over the long term. I admit the idea of a check list of investing may sound boring to some but having a methodical approach is likely to reward those who are disciplined enough to apply it. Charlie Munger has long advocated a checklist approach as a simple method to reduce risks of errors. “Checklist routines avoid a lot of errors. You should have all this elementary wisdom and then you should go through a mental checklist in order to use it. There is no other procedure in the world that will work as well.”
Possessing years of experience or access to multiple reports still does not stop the best investors from occasionally making errors in judgement. Formal checklists are common places in professionals such as aviation and medicine where lives are at risk Malcolm Gladwell, the author who coined the term ‘the tipping point’, describes in his book ‘Blink’ how the process of diagnosing heart attacks patients in a busy Cook County Chicago hospital emergency room was improved by the use of a simplified three question check list. Doctors were asked to collect less information and focus on three key criteria such as like blood pressure and fluid in the -while ignoring everything else like the patient's weight, age and medical history. As a result the hospital is now one of the top hospitals in the US in diagnosing chest pains.
In a world where investors are bombarded with constant information an investment checklist helps to filter out irrelevant information to allow focus on the key criteria for why a business succeeds and if it is a good buy. In fact Buffett has mentioned he has a mental checklist of four simple criteria when evaluating a business:
- Do I understand this business?
- Does the business possess a competitive advantage (economic moat)?
- Is the management able and honest?
- Is the price right? If so write the cheque.
In an investing environment with ever increasing investment options and complexity a check list will avoid many common errors of omission. We have all had the experience of finding what looks to be a sure-fire opportunity that we believe has been overlooked by crowd. Many value investors and fund managers have admitted in the past that if they had used a checklist it could have avoided costly investment mistakes during these heated moments! In a Forbes interview Mohnish Prabai the US fund manager who once bided US $650,100 for a charity lunch with Buffett confirmed that he now has implemented a formal checklist to systematically avoid repeating investment errors in the past.
Common check list areas include a mix of financial ratios (i.e. interest cover, debt to equity) and qualitative questions (do management have a stake in the business). Most of the answers should already be quite clear and going through the process should take less than an hour unless something striking appears or you lack the information which would prompt further research. One of the questions recently included in my checklist includes asking whether the sales revenue figures are based on boom-time earnings.
For example, are the current earnings estimates of Australian mining companies based on resource prices remaining stable or increasing? The revenue and profits of miners and mining services companies such as BHP and Monadelphous are linked to the prices of resources. Since resource prices have been increasing over the last several years due to booms in China and India this has led to good profits for many Australian resource companies.
However even without a prolonged slowdown in China it is likely that resource prices are unlikely to be maintained over the longer term. Note that when it comes to markets for iron ore, oil and even gold the only available tool to predict prices comes from using technical analysis which for fundamental value investors is an area we try not to rely too heavily on.
I'm interested to know what are some of the other checklist questions that people currently use and also what is your opinion on the ideal number of questions to be included on a checklist to avoid over analysis paralysis?
